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Detroit's Bankruptcy Is Just Politics By Other Means

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Carl von Clausewitz (Photo credit: Wikipedia)

Prussian military theorist Carl von Clausewitz famously declared war is "mere policy by other means." Detroit's bankruptcy is similar. Saddled with billions of dollars in bond debt and pension obligations it can never repay, Michigan's largest city has resorted to settling its deep-rooted fiscal and political problems in court.

By filing Chapter 9 bankruptcy, Detroit has effectively handed its fate over to a federal bankruptcy judge, along with the difficult questions of how to divide its inadequate resources among more than 100,000 creditors. Among other things, that judge will have to tackle the politically charged question of whether the city's public employees can jump ahead of bondholders and other creditors to collect pension payments that vastly exceed both financial reserves and the city's likely ability to repay.

"This was going to be battled out politically inside or outside of bankruptcy, and that's not going to change," said David A. Skeel, a professor at the Univeristy of Pennsylvania Law School who has written extensively about the political and legal questions swirling around government insolvency. "The court is a referee, an umpire, but ultimately the parties have to make the proposals."

Already, a Michigan state judge has declared the bankruptcy filing illegal because it violates a provision of the Michigan Constitution prohibiting any modification of public pensions. Federal law trumps state law under the U.S. Constitution's Supremacy Clause, however, so Skeel thinks there is a good chance the Michigan judge will be overruled eventually.

"I can't imagine that decision stands," Skeel told me, not least because no impairment of pensions has yet been proposed. He called it the "first salvo in a judicial process we're just beginning."

Congress first passed a provision of the bankruptcy code allowing for municipal bankruptcies back in 1934, which the Supreme Court promptly found unconstitutional for violating both the 10th Amendment (powers not explicitly granted to Congress are reserved to the states) and the clause prohibiting impairment of contracts. Congress slightly amended the law and the Supreme Court -- chastened by FDR's 1937 threat to pack it with more cooperative justices -- approved Chapter 9 in 1939.

Since then there have been relatively few municipal bankruptcies, although the number has ticked up in recent years. Much like airlines, which entered a serial bankruptcy phase after the industry was deregulated in order to rework union contracts, more cities  have turned to federal bankruptcy court to solve intractable disputes over debt loads and public pensions. The city of Vallejo, Calif. was prohibited under state law from closing non-essential fire stations or modifying pensions, for example, but achieved both in bankruptcy court.

When Skeel wrote an influential article proposing the equivalent of Chapter 9 for overleveraged states, critics said "no real city uses Chapter 9," he said. With Detroit's filing, that statement is no longer accurate. "I really think it changes your perspective on that, and it forces you to think Chapter 9 is one of the main tools in the tool kit when a municipality is in trouble."

Is that a bad thing? Skeel thinks not. Cities like Detroit -- and states like Illinois, California and Connecticut -- got into fiscal trouble because their political leaders spent too much and promised too much to public-sector employees in the form of future pension benefits. That's a fundamental problem with elective politics, of course: It's easier for today's politicians to make promises they can't keep than deliver financial reality to their constituents. In that sense, pension underfunding is one of the main tools politicians use to get around state laws requiring balanced budgets.

"Bankruptcy doesn't fix that problem," Skeel said, but it might make politicians think twice about making pension promises they can't keep, especially since many of them participate in the same plans, with higher projected payouts than typical employees. (One senior Texas legislator stood to earn 660% of his state salary in retirement, Skeel's article notes.)

"One problem with unsustainable pensions is we really didn't have both sides at the bargaining table," since politicians were the beneficiaries of both pensions and the votes of government employees. "The bankruptcy option forces the parties, particularly the recipients of these pensions, to recognize they may not be sustainable in a reorganization."

Michigan, like other states, has attempted to protect municipal pensions through its constitution. But Skeel thinks a federal judge, compelled under the law to treat creditors equally, might limit that protection to the portion of the pension backed by actual pension assets. The promise of future payments might fall into the category of an unsecured debt, although courts haven't actually decided this precise issue yet.

Skeel is criticized by Richard C. Schragger, a professor at the University of Virginia School of Law who says it is incorrect and unfair to blame the problems of cities like Detroit on their elected leaders. Detroit, like a lot of northern industrial cities, is also the victim of state neglect and laws that allowed affluent suburbs to shield themselves from the city's financial problems. As businesses and rich citizens moved outside the city's borders, Schragger said, Detroit was left with 700,000 mostly poor residents with the same demand for schools and other government services.

"People say the decline is attributable to bad management, but that's just not the reality," he said. "There are structural impediments to their well-being, and you can ignore those."

Schragger has argued bankruptcy unfairly yanks such questions from the political realm, and may give cities cover for pushing the costs of insolvency on city employees and the poor, while protecting creditors.

But Skeel says the opposite is more likely to occur. Bankruptcy judges are specifically prohibited from ordering cities to raise taxes or change spending, he said, and they must treat creditors in a similar manner. The main effect of filing Chapter 9 is the possibility of restructuring public pensions, he said, which simply can't be accomplished outside of bankruptcy. By forcing creditors to take haircuts on their bonds as well, he said, a judge might help inject a little fiscal discipline into the financial system by raising interest rates on profligate spenders.

The examples of governments from Greece to California to Argentina argues otherwise, however.

"Just increasing the cost of borrowing doesn't stop people from borrowing," he acknowledged.

In Clausewitz's day, that's when the armies marched to plunder new territories. Detroit and its many creditors can only slug it out in court.